Statement to the Congress - Federal Reserve's position on Savings Association Insurance Fund, deposit insurance - Transcript

Federal Reserve Bulletin, Oct, 1995

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services, US. House of Representatives, August 2, 1995

I am pleased to be able to appear here today to offer my thoughts on the status of the Savings Association Insurance Fund (SAIF) and on deposit insurance more generally.

The combination of deposit insurance and a central bank providing discount window credit has made the contagion of bank runs that often characterized the nineteenth century and the first third of the twentieth century an anachronism. The United States has not suffered a financial panic or systemic bank run in the past fifty years. In large part, this reflects the safety net, whose existence, as much as its use, has helped to sustain confidence.

But deposit insurance is not without its costs. By relieving depositors of the consequences of bank failure, government guarantees of bank deposits make depositors relatively indifferent to bank failure and thus encourage banks to have larger, riskier asset portfolios than would be possible in a wholly market-driven intermediation process. Without the safety net, additional risks would have to be reflected in some combination of higher deposit costs, greater liquid asset holding, or a larger capital base, and these, in turn, would constrain risktaking. In the late 1980s and early l990s, the Congress responded to problems at insured depository institutions - and their insurance funds - with legislation designed to induce these entities to be more prudent risk-takers.

Today, we are here to address an evolving competitive imbalance and other implications of two insurance funds with sharply different premiums. But it is critical to underline that even if there were no evolving problem with SAIF, the existing deposit insurance system, with its reliance on two funds, would be inherently unstable.

With deposit insurance, as it is currently administered and funded, depositors do not move their funds from depository institution to depository institution based on the soundness of particular insurance funds. Depositors are generally unaware, and indeed should be unconcerned, about the Bank Insurance Fund (BIF) versus SAIF. In the mind of the typical depositor, the Federal Deposit Insurance Corporation (FDIC) provides the insurance, and the details of one fund versus another receive little attention.

Competitive depository institutions cannot differentiate themselves by the quality of the deposit insurance that is offered because it is the same insurance regardless of whether it is from BIF or SAIF. In either case, it is government-mandated and government-sponsored deposit insurance. For identical insurance, it is rational that depository institutions seek the one available at the lowest cost. If a substantial difference in deposit premiums exists between SAIF and BIF, the institutions paying the higher premium will pursue insurance offered by the other insurance fund unless there is some other reason to remain with their current fund.

Although today we are discussing what to do about SAIF, I want to stress that the problem we are addressing is a general one. If there is no substantial difference between BIF and SAIF insurance and if there is no substantial difference between the advantages granted to BIF institutions or SAIF institutions, then anytime one deposit insurance fund has difficulties that result in substantially higher deposit premiums, members will try to shift to the other deposit insurance fund. In the process, the disadvantaged fund becomes increasingly vulnerable to insolvency as its premium base declines. This, in turn, engenders a still greater incentive to leave the troubled fund or requires the payment of still higher premiums to support it. Short of effective barriers to exit, once initiated the downward spiral does indeed lead to fund insolvency. Thus, having two deposit insurance funds creates a mechanism that is prone to instability now, and probably in the future. Today, the problem is at SAIF; it may, at some date in the future, be at BIF.

The Congress can attempt to legislate barriers that try to stop institutions from shifting deposits, but the history of efforts to legislate against such strong financial incentives is not encouraging. We are, in effect, attempting to use government to enforce two different prices for the same item - namely, government-mandated deposit insurance. Such price differences only create efforts by market participants to arbitrage the difference. In the present case, with SAIF institutions expected to pay at least five times more per year for the same deposit insurance, this arbitrage means that SAIF institutions will pursue all avenues open to them profitably to move deposits from SAIF to BIF.

The difference between paying, say, 24 basis points and paying 4.5 basis points for deposit insurance translates into about $1.4 billion per year in additional premiums paid for SAIF deposits. For SAIF institutions, this equals roughly 18 percent of their 1994 pretax income. Given the large potential financial gains to SAIF institutions if they move deposits to BIF, the current deposit insurance system will impose a large dead-weight loss on the financial system. Many of the political, policy, financial, and legal institutions concerned with banking issues will be preoccupied, for the foreseeable future, with the details of this issue because SAIF institutions will continually strive to move deposits into BIF and BIF institutions will attempt to thwart such movements.